The Ex Ante Factor: Another One Bites the Dust

Financial institutional blow ups are getting larger and seem to be happening
with more frequency. The latest debacle at Soc/Gen can be seen as a natural
progression of the trend of larger and more leveraged trades which seem to
inevitably find their way down the toilet. The common denominator behind all
of these financial implosions is a tremendous amount of leverage and an increase
in volatility. Orange County was interest rate derivatives, LTCM was about
massively levering convergence trades, Amaranth was commodity derivatives,
Bear Stearns was highly leveraged structured products and of course Soc/Gen's
$7.2b loss in un-hedged equity index futures gave them the dubious honor of
history's largest blow up. I don't mean to bemoan derivatives as they are a
highly valuable tool. Like with these specific events, it's usually the speculator
who gets taken out not the hedger. It is the capitulation of these leveraged
speculative positions that can often mark turning points in markets.

On Jan 20, the day before all hell broke lose in the European futures markets
as the US was closed for MLK day, we wrote in Jack
Be Nimble:

We have also seen a credit market correction in the SPX from the October
2007 top that equals the LTCM correction in price at 1307. We aren't suggesting
the declines are over or that we are in store for a 50% rally, but the inter-bank
market is normalizing and the stock correction is near extreme levels and
is starting to look cheap.

Of course we had no idea we would wake up Monday to witness the unwinding
of a larger melt-down than LTCM. At extremes strong hands (real money) shake
out the weak hands (leverage). We knew the market was at an extreme and were
looking for some capitulation and volatility spike to put in a low. That is
precisely what we got when Soc/Gen sold out of their position.

The previously mentioned financial debacles all marked turning points in the
markets. It's important to realize that this is not a coincidence. What we
have when a financial institution blows up is a cleansing of the market. The
leverage is extreme, volatility picks up and the weak hands can't take the
swings to their balance sheet so they puke leaving the market to the strongest
of hands (like Berkshire Hathaway).

When Orange County went bankrupt in 1994 it was essentially a bad leveraged
carry trade bet on inverse floaters that got blown out when the Fed raised
interest rates from 3.25% in Feb to 5.50% by the end of the year. The 10YR
yield went from 5.50% at the beginning of the year to almost 8.00% by the time
they threw in the towel and declared bankruptcy in Dec. To this day the 10YR
has not been as cheap as it was when they puked. Stocks had a rocky year in
1994 and basically bottomed in a higher low around 450 on the S&P 500.
The following advance would take stocks on a 150% rally into the next debacle
when LTCM blew up in 1998.

Ironically LTCM was founded in 1994 and was also employing a highly leveraged
carry trade. The trade got too big and when volatility spiked surrounding the
Asian and Russian problems (and Monica Lewinsky), the convergence diverged
and their positions were too illiquid to unwind. They were trapped. When they
finally were able to unload their positions, to the Wall Street banks who were
their counterparties, there was a $4b loss to the fund. The S&P bottomed
in Oct around 925 and with the system shaken out, embarked on an unprecedented
rally of 60% into the Mar 2000 top.

In 2006 the market experienced a substantial correction and saw a similar
spike in volatility as the S&P came off a May high and declined 8% into
a June/July double bottom. Over the same time natural gas prices were coming
off a parabolic high from the 2005 Katrina hurricane that saw prices spike
over $14. By May of 2006, the price had fallen by 50% to the $7 area but this
massive decline was not what took down Amaranth. It was the subsequent fall
to just under $5 as they were increasing their leveraged long positions that
became so large reportedly everyone in the pit knew about it. Chicago based
Citadel and JP Morgan took down the positions on a "clean up" trade at a substantial
discount and the stress was relieved. Volatility subsided and with the market
cleansed it continued it's bull market rallying 25% into the 2007 highs where
we found ourselves facing another historic debacle.

As you can see the long term trend line of BSC has held during tumultuous
events such as the bond bear market of 1994 (Orange Co blow up), the 1998
de-leveraging of LTCM and the 2000-2002 equity bear market. Bear Stearns
has always been a top mortgage bond shop and they are arguably one of the
more highly exposed investment banks, hedge fund blow up not withstanding,
to the sub-prime and subsequent CDO implosions. Is this an isolated event
or the tip of the iceberg? Judging by this chart showing some breaching
of the trend line with a deteriorating RSI we would be on the lookout for
further troubles in the mortgage/collateralized debt market and the subsequent
losses in BSC's stock price. The XBD is viewed as a leading market index
and a breakdown in BSC should be viewed as a warning for the overall market
condition.

Obviously the BSC hedge fund blow up did not mark a low in stocks but it did
mark a low in treasuries and no doubt was an omen of more pain to come in leveraged
credit. In June we were waking up to massive selling in treasuries with the
10YR yield rising 75bps from the Feb lows and 50bps in Jun alone. The BSC highly
leveraged structured finance mortgage portfolio was the poster child for the
credit bubble and when they started seeing redemption requests and a liquidity
squeeze, they presumably unloaded what they could to raise cash, which were
their treasury hedges. The implosion of these funds was the first domino to
fall and we are still feeling the repercussions. Since the blow up treasuries
have been one of the best performing assets. Just months later the bond contract
rallied 15 points (14%), 10YR yield is down to 3.50% with the 2YR down to 2.00%
as the de-leveraging they ignited has driven a flight into risk-free assets.

Recognizing we are in a cycle of de-leveraging should in theory keep speculative
leverage at a minimum. Being highly levered while others are de-levering can
be a painful experience. That is the lesson of Soc/Gen's debacle. The details
are still vague but we can be sure of one thing, this guy bit off more than
he and the whole company could chew. The market was shaking out the weak hands
and they couldn't handle the volatility. Since the apparent unwinding of their
position and subsequent announcement of the trading loss coupled with the Fed's
massive 125bps easing to cushion the selling, we have seen a nice 10% rally
off the Jan 23 low.

Did Soc/Gen's puke put in a low or shall we be seeing further financial debacles
that need to shake out the weak hands? We are fairly certain we will see further
unwinding of overly leveraged positions in the future and the all pain is not
behind us. The problems with the bond insurers and the potential ripple effect
caused by their failure come to mind. However, the capitulation low put in
as Soc/Gen was forced to sell that massive leveraged long position is similar
to other historic disasters and thus potentially marking a turning point in
the market. As of now we prefer to trade as if we are putting in some sort
of bottom. The rally off the low has been impressive and brisk thus we are
looking for a pullback next week. That said, we are buyers on an orderly corrective
pullback and will look for higher prices in the weeks to come. We are not dropping
a defensive posture but if this market has cleansed itself of the weak and
leveraged positions we want to be exposed to higher prices.

Addendum: One of the biggest lows in recent memory was the 10/02-3/03 low
in stock prices. This was not caused by a financial debacle but there was
a very influential event that took place. The S&P 500 bottomed on 10/10/02
at 768.63. The next day the Senate approved the Iraq War resolution which
gave permission for the President to disarm Saddam. The 3/03 low coincided
with the actual invasion.

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Have a profitable and safe week trading, and remember:
"Unbiased Elliott Wave works!"

This update is provided as general information and is not
an investment recommendation. TTC accepts no liability whatsoever for any losses
resulting from action taken based on the contents of its charts, commentaries,
or price data. Securities and commodities markets involve inherent risk and
not all positions are suitable for each individual. Check with your licensed
financial advisor or broker prior to taking any action.